Progress Despite Uncertainty — Where to from Here?
The constant theme of my most recent blogs has been to keep the faith when it comes to global economic recovery and equity markets, but to be very wary of extremely overvalued bond markets. As I look to the second half of the year, I find myself having a Groundhog Day moment as essentially my message remains unchanged. Interestingly, while equity markets and economies have generally behaved as I might have expected during the first half of the year, the factor that has dominated returns for clients was currency movements. I expect less currency volatility from here out with the large moves mainly behind us. I am not in the strong dollar consensus camp and believe currencies may well just range trade near term.
At present, economic fundamentals have taken a back seat to politics and specifically the politics of Greece and the eurozone. I see the current crisis as a challenge that is all about the political will of European political leaders and Greece, not economics or debt levels. The results of last weekend’s poll in many ways change little, other than raising the stakes for continuing the negotiations. Both Greece and her European partners over coming days, weeks, or possibly months need to decide whether continued membership of Greece and for Greece is a price worth paying for both. Although the instinctive reaction to the poll results is that the chance of collapse has risen, perversely with the theatre of the weekend now out of the way and the resignation of the truculent Greek finance minister, the chance of compromise may actually have risen.
Away from the politics, my bottom line from an investment perspective at present is:
- Greece is not a Lehman moment for global markets; not least the global economy and financial system are on a much sounder footing than a few years back.
- The ECB is a very powerful force and has many weapons at its disposal that can be used to underpin the financial system in Europe if necessary.
- I do not expect significant contagion across Europe as a result of Greek uncertainties. Of course on a much longer term view, should Greece exit the euro, it would be a medium term negative for the eurozone.
- Finally, important to state, our portfolios hold no direct Greek assets.
Given the rapid sell-off in bonds in the second quarter, I retain my confidence that we have most likely seen the lows of the cycle for bond yields, and from here we should expect higher highs rather than lower lows for global bond yields. A world of gradually rising interest rates and inflation has historically not been positive for bond markets.
As for equity markets, on an absolute basis after a now six-year bull market, they cannot be defended as cheap and are somewhat above fair value. The increasingly consensus view (worryingly?) amongst investors is that equities are therefore the asset class of choice for investors. This view is supported by the argument that with zero returns available from cash and the prospect of negative returns from global bonds, where else do you invest to achieve positive returns? While I don’t always sit comfortably with the consensus, in this case I remain glass half full and believe that equity markets can make further positive returns over the next 12-18 months for investors. As long as I see no signs of complacency or exuberance, I am comfortable that this remains the case
I do strongly advocate that the next phase of the investment cycle will require more active management and skillful asset manager decisions around what regions and equity types to own. In April I began warning on this as I wrote about market breadth in the U.S. market, “While I remain generally relaxed, I am not relaxed with what I perceive to be quite a narrow and unhealthy U.S. stock market.” During the second quarter we have seen some style rotation and change in leadership in the market which I see as positive and a more healthy market background. As confidence in recovery and risk taking picks up as it should over coming quarters, I would expect this rotation to continue and the broadening accelerate.
So while keeping the faith, there are naturally risks and uncertainties to highlight:
- Greece is clearly on everybody’s radar right now. The Greek situation clearly remains a very fluid and volatile one .It is dogged by uncertainty and a rapidly changing situation which we remain ever alert to. It will likely guide near term market direction.
- As we approach September, the U.S. Federal Reserve will probably raise rates for the first time in many years and in line with consensus thinking. The markets may well worry about it, so communication surrounding the move will be of paramount importance- rationale for same and path of expected future raises.
- The outlook for Chinese growth remains critical. Having been slowing for many quarters, the government has been proactively targeting sectors for spending as well as the central bank cutting interest rates to underpin the economy. The volatile domestic Chinese stock markets themselves have been vying with Greece for headlines over recent weeks.
- The eurozone economy has been resilient through the first half of the year and has been a pleasant surprise to many investors. It will be crucial that this positive momentum is maintained and we don’t get a relapse in growth.
To conclude, I remain positive on the outlook and despite the constant uncertainties be they economic or geo-political, markets continue to generate positive returns, and I believe this will continue to make progress. We are at a more mature point in the market cycle, at a juncture where economic growth and earnings are important and a sustained momentum of economic growth matters most. I remain confident that markets will make further positive progress. I continue to emphasize stocks with strong cash flows, attractive balance sheets, and strong and well managed businesses.
Chief Investment Officer
Kleinwort Benson Investors International
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